Rainy Day Funds: Did the Lifeline Work?

As revenues return, legislators and policymakers are beginning to take stock of how well their rainy day funds functioned.

Penelope Lemov is a GOVERNING correspondent. She was GOVERNING's health columnist and was senior editor for several award-winning features.

In Texas, officials have been squabbling over whether or not to tap their rainy day fund, which as of Jan. 1 had upwards of $9 billion in it. While the governor and Legislature initially agreed to use $3 billion of it in the current biennial budget, they can't reach an accord on the remaining $6 billion. As a result, the state is planning massive cuts in education and health care to close a $26 billion shortfall in the upcoming biennial budget.

Texas' resistance to using its rainy day fund is somewhat unique. Seventy percent of states with rainy day funds tapped them during the Great Recession. Some drained them almost dry; others left a small puddle of cash. "The rainy day funds worked as they were supposed to," says Scott Pattison, executive director of the National Association of State Budget Officers (NASBO). "It rained. It stormed and poured. And most states used them. They get a lot of pats on the back -- or should -- for having used them."

As revenue begins to tick up ever so slightly in a number of states, legislators and policymakers are beginning to take stock of those funds and how well they worked: Were they easy -- or too easy -- to use? Was the money in the funds adequate? Should adjustments be made? When should refunding begin?

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To get some perspective on these issues, I talked to Pattison and Elizabeth McNichol, a senior fellow at the Center on Budget and Policy Priorities (CBPP). An edited transcript of our conversation follows.

Was there enough money in the rainy day pots?

Elizabeth McNichol: The conventional rule of thumb had been to put 5 percent of expenditures in a stabilization fund. We looked at the recession in the early 1990s, which was a relatively mild one, [and found that] what a state needed to get through that one without significant cuts or tax increases was 15 percent. Some states that had caps of 5 percent raised them to 7.5 percent or 10 percent. Given the experience with this last recession, a number of states will find it easier to raise their caps.

Scott Pattison: You could argue that the funds weren't sufficient. No one predicted the recession would be quite as dramatic in terms of loss of tax revenue as it was. I would argue that we should strive for higher percents. From 2005 to 2007, when things looked good, states put significant amounts of money in their rainy day funds -- well over 10 percent overall. When they really needed it, the funds were there and they used them. Did it help prevent some of the more draconian cuts? Sure, they had to make significant cuts but if they didn't have those funds -- oh my gosh! I wouldn't be surprised if a few begin the process of changing requirements so that they can put in more.

Is it time for states to start refilling the funds?

SP: If you eliminate Texas and Alaska -- both of them have huge rainy day funds that they haven't tapped -- then fiscal 2010 balance levels represent only 2.4 percent of expenditures. States still have strong memories right now of the difficult time they've been through, so they are going to have a real positive awareness of the importance of rainy day funds. As states feel their finances are more stable, they're going to feel more comfortable talking about the process to put funds away.

A lot of states will have a little extra money at end of this fiscal year. In a lot of those states, there are requirements that some of it go into the rainy day fund. In some cases, it's formulaic. They have regulations for what goes into rainy day funds and when it starts to kick in. This is particularly true at the end of a fiscal year for almost every state that has a surplus. We are switching now to a period in which budget gaps are based more on spending requirements than declines in revenue. Revenue is improving but the required expenses -- structural things -- are still there. States are going to be cutting because expenses are still higher than revenue coming in, but they'll be putting some money into the rainy day fund.

EM: A few states that don't have rainy day funds -- Arkansas, Colorado, Illinois, Kansas and Montana -- will be looking to establish them. As to funding, just recently Massachusetts added a change to their rainy day fund that will deposit any revenue from capital gains taxes that exceeds $1 billion into the fund. It may be that states will look to volatile revenue sources and use appropriations of those to build up rainy day funds.

Why have some states not tapped into their rainy day funds?

EM: In some states, they argue that bond rating agencies want them to have a certain balance in the fund. The problem with that argument is that the reason the bond agencies want them to have the funds is to smooth things out when there are downturns. In other states, the rules surrounding use make it difficult to use the funds. Twelve states require that reserve funds be replenished quickly when used, making them almost useless in a steep downturn with plunging tax revenue. Ten states require a two-thirds vote of lawmakers to use the funds, discouraging some legislatures from even attempting to get to the dollars. Others have such onerous rules that they have used their reserve dollars only in a limited fashion, or not at all.

Both CBPP and NASBO have extensive reports about the current and historic state of rainy day funds on their websites.